Tag Archives: financial crisis

Reinventing Regulation

by Larry Grant

If one could remove oneself from the panic of the financial crisis, it could be instructive—even amusing—to see if this crisis does, in fact, take the course described by its antecedents:  Crisis, regulation, co-option.  Let’s hope not, but, cynical me, I expect the worst.

The worst in this case would be a rush to regulation that, in typical bureaucratic fashion, will create a new regulatory body based on legislation that will require a one-size-fits-all Procrustean bed.  This will be especially worrisome if the push for regulation of the financial institutions and the markets they play in goes beyond to other institutions/companies the Treasury decides to invest in where the player is too big to fail.  Also, I worry that market forces and public investments will result in further mergers and acquisitions in the banking industry creating even more concentration that we can’t afford to bail out.  (See “Both Sides of the Aisle Say More Regulation, and Not Just of Banks,” Jackie Calmes,  New York Times.)

What we need is regulation that is focused on the specific situation of the institution or product being regulated—e.g., not all banks, this bank; or insurance products by any other name (like “credit default swaps” maybe?).  I found it encouraging that Gary Stein, President of the Minneapolis Federal Reserve Bank appears to support an approach that uses specific data from financial institutions that would indicate existing or future problems so that regulators could act before it is too late.  (Gretchen Morgenson, “Regulators In Need Of Rehab,”  by Gretchen Morgenson, New York Times)  Put another way, Floyd Norris writes in the New York Times that “[o]ne principle of the new regulatory system must be that regulations are based on what people do, not on who they are.”

If you are a reinventor faced with designing a regulatory or control functions, we have a basic approach that, over the last two decades has been continually refined.  This approach has three conceptual dimensions focused on the “situation” of the complier (the institution or individuals to be regulated):  Willingness to comply, Ability to comply, and Risk associated with non-compliance.  (Note:  this approach began with the thinking of Hersey and Blanchard  and their concept of “situational leadership.”)

Taking each of these dimensions independently, the concepts are that differences in willingness to comply, ability to comply, and the risk of non-compliance should have different regulatory responses or demands.  For example, if someone is willing to comply, it doesn’t make sense to treat them as a target for criminal enforcement.  Maybe all they need is the best information about how to comply or the social consequences of non-compliance, or just feedback on the degree to which they are complying.  Why bear the cost of stationing a traffic cop on a stretch of road when a simple radar-enabled sign provides feedback on speed?  In some communities this latter approach is much more cost effective to bring down the speed of traffic.  However, where those to be regulated are not willing to comply, information won’t work—enforcement is necessary.

This is similar to an assessment of a complier’s ability to comply.  For example, some states have found that their tax forms had become so complicated that people had great difficulty paying the correct amount.  By simplifying the forms much higher levels of compliance were achieved without the great additional expense of more auditors and tax enforcement personnel.

In the case of risk, the reinventor needs to keep in mind the risk or cost involved in non-compliance, and the relative cost of regulation.  One needs to take a different approach to regulation if the risk is high, than if the risk is low, or if the cost of regulation outweighs the cost of non-compliance.  A common example is where it costs several hundred dollars to process a procurement form for a product or service that only costs a few dollars, and the risk is very low if the “wrong” product or service is, in fact, procured.  Or take Russian roulette.  As Norris says, “even a low probability event may represent an unacceptable risk.  Few of us would play Russian roulette, even if the odds were wildly in our favor, because it is a game no one can lose twice.”

The challenges in making this approach to regulation work are the issues of resources and metrics.  In other words, the regulator needs to have the tools and ability to assess the relative willingness, ability, and risk involved.  Otherwise, the path of least resistance (for the bureaucrat and the elected official) is one-size-fits-all.  And we know where that path leads.